Retirement Account

The Pros and Cons of Borrowing from Your Retirement Account

Learn the pros and cons of borrowing from your retirement savings.

Dec 29, 2014

The Pros and Cons of Borrowing from Your Retirement Account

The financial gurus in the popular media often attempt to offer advice using broad generalities in an attempt to make their points of view applicable to a wider audience. I tend to agree with much of the general advice offered in relation to retirement savings. Start saving as soon as possible, increase your savings as your disposable income grows, select a well-diversified portfolio, rebalance your account periodically; all of these tips make sense for most of us.

One Size Does Not Fit All

Financial columnists and journalists almost universally will advise us to avoid borrowing from our retirement savings accounts, at all costs. While I do agree there are distinct negative consequences that will affect the future growth of your account, I do not completely agree with the common logic associated with these arguments.

Let me be clear, there are real risks associated with borrowing. However, many of these same risks are inherent in any borrowing.

If you live your financial life precariously close to the edge, you run the risk of falling off. Many employees find themselves looking to borrow from their retirement account as a last-ditch effort to avoid going over the cliff. Many participants successfully use plan loans as a financial lifesaver.

Some of the Common Arguments Against Borrowing from Your Retirement Plan

If you resign or retire prior to paying off your loan, it will become due and payable – for a long time, this was the standard practice. This was true not because the tax code required it, but because neither employers nor their service providers were equipped to begin taking payments directly from terminated participants. Most participant loans are repaid through payroll deduction, which simplifies the repayment process for employers and employees.  However, with modern conveniences such as electronic fund transfers (ETFs), many providers are now willing to accept loan repayments directly from terminated participants.

In fact, BPAS has even developed MyPlanLoan as a service to employers and other providers in the retirement plan industry to help facilitate loan repayments for terminated employees. BPAS believes that by allowing terminated employees to continue to repay their outstanding loan, they will also be encouraged to leave their accumulated savings intact, rather that withdraw prematurely.

The taxes and penalties for early withdrawals of your retirement savings can be significant. In addition to income taxes, if you are younger than 55 when you terminate, you are subject to an early withdrawal penalty of 10% of the unpaid loan. As scary as this sounds, the likelihood is that if an individual choses to borrow commercially, the loss of their job will probably result in the loan repayments being unaffordable and require the withdrawal from the plan to pay off the debt. Such a withdrawal would be subject to the identical taxation and penalties. If the termination is the result of a job change, repayment of the loan should have been a consideration. Job changers may have some options.

You will be missing out on investment income potential while the loan is outstanding – while this initially seems to make sense, there is one flaw in this argument. It assumes that the markets will steadily rise during the time the loan is outstanding. So, if you happen to have the worst timing ever and borrow from your 401(k) as the market is beginning its next big rally, the real opportunity cost of borrowing is the difference between the return your liquidated investments would have produced and the interest rate you are paying yourself. That would be bad.  However, if you happen to borrow from your account at the beginning of an economic downturn, it is possible that the interest you pay yourself may be the only positive returns in your portfolio.

As long as you can afford to save at the same rate you were saving before you take the loan and can afford to make your repayments on-time, the lost investment earnings should have a negligible impact on your overall retirement savings.

Participant loan repayments are “taxed twice” – this one is interesting. If you follow the exact dollars used to make the repayments, they are technically taxed twice. Loan repayments are made after income taxes are withheld from your paycheck and, then again once you withdraw the funds from your account.

If you compare this to commercial borrowing, your retirement account would remain intact and you would pay taxes on it when you withdraw the funds. The repayments to a commercial loan would be made out-of-pocket from dollars that have already been taxed. There really is no difference in the taxation of the dollars used to repay either loan.

Employers are not required to offer employees retirement plan loan privileges. However, the majority of plans do allow employees this access. Studies have shown that having the ability to borrow encourages lower-income employees to begin saving. The knowledge that they may be able to access some of their savings in an emergency provides a certain level of comfort.

Can You Borrow from Your Savings to Pay Off Debt?

Participants that abuse this privilege do indeed negatively impact their financial futures. However, those that make a calculated decision to borrow from their retirement savings often consider many factors in the decision-making process. An employee that is saddled with extensive amounts of commercial debt (credit cards, car loans, etc…) often finds themselves needing relief. A loan from their retirement plan can be a good decision.

A plan loan could also be preferential to various other debt consolidation options. By borrowing from themselves, they do not negatively impact their credit ratings…quite the contrary actually. Since a plan loan is not reported to the credit agencies, by borrowing to pay off debt, they may positively affect their credit scores, especially if they payoff and close some of their outstanding credit lines.

So, rather than establishing another outside means to meet their financial obligation and become indebted to that outside party, employees using their loan provision can actually manage their own finances and improve their financial position.

Here Are Some Advantages

  1. The interest rate with the plan loan is lower than those available commercially because the loan is collateralized.
  2. Sure, there is still interest due on the plan loan, but employees are paying that interest into their own account, which increases their account balance. Interest repaid on any outside loan would not benefit the employee or their account.
  3. By financing their own loan, they do not incur the investment expense associated with an outside loan.

Sadly, there is a lack of basic financial education in our country. Eliminating commercial debt and learning to finance purchases from current income and savings are two sound pieces of advice. And while it is not my intention to condone reckless borrowing from retirement plans, there are times when employees need additional liquidity. Understanding how to best utilize the savings they have generated to their advantage with those points in mind is another good lesson in fiscal responsibility.